The ETF industry has attracted record new business in four of the last five years © Dreamstime

The exchange traded fund industry has swelled to $4tn this year, propelled in part by a dizzying array of innovative, new products. But one corner of the passive investment landscape has remained a barren wasteland — until now.

While there has been no shortage of experimentation in equity ETFs, with a growing number of so-called “smart beta” funds designed to give exposure to specific investment factors like growth stocks or even quasi-hedge fund strategies, bond ETFs tend to be fairly plain in comparison. 

A simple bet on bonds has been enough to make money for more than three decades. However, with some writing the obituary for fixed income’s bull market, more investors are tempted to explore the gizmos Wall Street is now offering that bring so-called factor investing deeper into the bond universe.

Smart beta is the investment industry’s jargon for ETFs that attempt to improve returns by going beyond simply mimicking a traditional index like the S&P 500 for equities, or the Bloomberg Barclays Aggregate bond gauge, by weighting their composition towards certain factors that tend to perform well over time.

Financial engineers at big asset managers are starting to churn out more next-generation fixed income ETFs that go one — or several — steps beyond simply trying to mimic the performance of a bond index. 

Chart: 10 biggest smart beta bond ETFs

“This is the next frontier of factor investing, and will become the next battleground as money begins to pour in,” predicts Rob Nestor, head of BlackRock’s US iShares smart beta team. 

Less than a decade ago, Morningstar, a data provider, had only registered two “non-traditional” bond ETFs with assets of about $200m, managed by Invesco’s PowerShares. One invested in liquid, emerging market bonds issued in dollars that mature in at least three years, and another was a bespoke junk bond ETF. 

Today, Morningstar tracks 23 such non-traditional bond ETFs, with total assets of nearly $10bn. Although that is dwarfed by nearly $600bn of smart beta equity ETFs, industry insiders expect much more innovation in the fixed income landscape in the coming years. BlackRock has counted 25 smart beta bond ETFs, and Mr Nestor says another 25 have been registered with the Securities and Exchange Commission, and are awaiting approval to launch.

These new strategies arguably make even more sense for bond ETFs than equity counterparts. Almost all major indices are “cap-weighted”, in other words, the bigger the company the bigger its weighting in an equity benchmark. But for bond gauges, this means the more indebted a company or country, the bigger it is in an index. 

In practice, this perversely means that passive investors end up lending even more money to already heavily-indebted borrowers. To take one example, the US, Italy and Japan together make up over half of the entire $47.5tn Bloomberg Barclays Global Aggregate, the biggest international bond index. In contrast, the debts of Brazil, Russia, India and China — the four Bric countries that now account for a big chunk of the global economy — only consist of 1 per cent of the index.

“Investing more in the biggest issuers of bonds isn’t necessarily the best way to invest in fixed income,” points out Todd Rosenbluth, director of ETF and mutual fund research at CFRA. “The next wave [of ETFs] will be these new smart beta bond products. We’re starting to see it.”

The lack of experimentation in bond ETFs relative to the equity universe is partly down to the fact that most academic research into investment factors has been focused on equities, where there is extensive and clean data going back many decades. In contrast, corporate bond trades have only been publicly reported since 2002. 

“The data hurdles are huge relative to equities,” says Rob Arnott, the head of Research Affiliates and one of the pioneers of the smart beta industry. “A lot of bonds are issued by companies that aren’t public, and even the price data can be hard to come by.”

But it also reveals some of the fundamental differences between stocks and bonds, with the latter far more idiosyncratic securities that often only trade intermittently, according to Riti Samanta, head of smart beta fixed income at State Street Global Advisors. That makes constructing liquid, alternative indices to track much trickier. 

“People have tried to jam an equity factor framework over fixed income, but it’s different,” she says. “In equities you can go out and buy all the stocks in the index, but you can’t necessarily do that in fixed income.”

State Street manages smart beta bond ETFs under its “Issuer Scored Corporate Index” strategies. These aim to maintain the same sectoral make-up as the broader indices, but tilt towards listed issuers with strong financial metrics — such as the return on assets — aiming to generate better returns with lower volatility.

Smart beta products are far more complicated than their plain vanilla, first-generation counterparts, and can perform differently in practice than the theory underpinning them indicates. This is particularly true for smart beta bond ETFs, which add another layer of intricacy. Their time may have come, but their promise remains unproven.

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